Avoiding an IRS Audit
May Not Be So Easy For Top Earners
There are things that make us more likely to be audited by the IRS. Apparently being a millionaire is one of them. 12 % of these returns were audited for 2011 up 50 % from 5-7 % from 2004-2009. This percentage goes down to 4 % for those returns between 250,000 and one million and below 1 % for those below 200,000. I was relatively surprised by these increases but do see the logic. The higher the income the greater desire to take financial risks on things that may be a deduction.
The type of entity also has an impact on who gets audited. A taxpayer who files a Sch C has a 4 times higher chance than a wage earner of the dreaded tax audit. This increases as the gross income goes up. Some of our clients have formed partnerships with spouses to avoid filing a Sch C and avoiding the increased chance of audit. Once selected now recordkeeping and presentation becomes the game. This is not a strong trait for many taxpayers.
Believe it or not most taxpayers estimate a great deal when filing their returns.This does not mean the IRS will accept this so here the work starts. Luckily certain items can be reconstructed. Automotive use is a prime example of this. Unless you do your own maintenance mechanics or dealerships will log your miles at each service. Taking a sample at various times of the year gives us a way to determine mileage. Now that this is documented we can turn to gas. We can determine miles per gallon and the average price paid for gas giving us another number. Insurance can normally be requested from an agent. Entertainment is another area ripe for reconstruction. A log is all needed here. Expenses under 75 do not even require a receipt. We do need to record date, time, location and purpose of the entertainment. Most other areas need the documentation and DO NOT as lend well to reconstruction. Other things that lend to being audited are large losses, gambling winnings, employee business expenses, high expense to income ratios and in essence anything else they want to see. The interesting thing is opposite to a court of law where we are innocent until proven guilty IRS is the exact opposite. We are guilty until proven innocent. Everything must be proven. There are no national averages or allowed expenses with IRS.
There are rules designed to avoid repeat tax audits on the same issues within a two year period. Unfortunately these are not always followed. I now have a case where they are insisting on the audit although two years before the same issue was audited and a no change occurred. The taxpayer is frustrated and I do not blame him. We can respectfully disagree with IRS. The normal method to do this is through the appeals process after attempts are made with the original auditor. This allows a new person on the case and their goal is avoiding tax court so they normally are more reasonable and are willing to deal. If a resolution is not achieved here tax court is the next step. Usually a tax attorney is needed at this stage as most CPAs are not able to do this.
To add to the fun the IRS is also now doing correspondence audits through the mail. I have found them very frustrating as it is hard to have several one sided discussions and get anywhere. Long gaps also take place due to handling several cases and IRS is normally one of the slowest organizations you will ever experience anyway. I got so frustrated recently I took a case to appeals and did not even charge the client and got a no change. Ironically this is the same taxpayer they are insisting on the repeat audit; amazing.
While it is allowed for someone to represent themselves at audit I do not encourage this. You do not likely speak their language and cannot really advocate positions as forcefully as someone versed in the law. A bigger reason is you have to answer all their questions. I can truthfully say we will get back to you allowing us to see the direction and hopefully develop a response superior to off the cuff responses. Any of us would normally like to be able to think about our response versus being interrogated.
The IRS is using the matching letter more effectively. This usually involves a list of things they do not see on the return matching their records. Remember many things get sent to IRS ie mortgage interest, stock proceeds, interest and dividend income, and many more. It may just be a location issue but now must be addressed. I have many taxpayers inquire about large differences in years causing an audit? The IRS does not have a way to compare years outside of audit so this is not a factor. All returns filed are graded by the IRS computers and those that grade high are kicked out for a manual review. No one knows the formula. Now individuals decide the returns that will be chosen for audit. The IRS does continue to improve their compliance methods. One simple thing they did years ago is require social security numbers from dependents. 7 million fewer were claimed the following year. Childcare ID numbers are also now required likely greatly reducing this area. The latest area to garner their attention is stock basis a long time area for question. They knew the sell side but not the buy. Now requirements are being made on the purchase side. In summary the IRS appetite is increasing and the taxpayer must be educated to avoid their wrath.